As we kick off the 2012 RRSP season, we’ll be running a series of 2-minute videos from various experts. This is a departure from the old Wealthy Boomer videos and the interview format. In this Twitter-age two minutes seems to be the limits of viewers’ attention on the web, so the series will be in effect monologues featuring each expert.

Each video will be accompanied by an article that will run in the upcoming series of RRSP special reports. You can get a taste of the videos by viewing the just-posted video featuring myself, in which I talk about investment management fees and the “Rule of 40.”

Readers may recall a series of columns and blogs at the end of the year, centered on a particular Winnipeg-based financial planning and mutual fund giant. You can find links to some of those pieces here.

The Rule of 40 goes back to 1998 and the publication of the book that spawned this blog (among other things): The Wealthy Boomer: Life After Mutual Funds. My two co-authors on that project were Michael Ellis (now at BMO Nesbitt Burns) and consultant Kelly Rodgers. By the way, the book is out of print although I see used copies floating around on the major online book sites, like this one.

The foreword to the book was written by actuary Malcolm Hamilton, who is part of our RRSP video series. In the book, his focus was on mutual fund fees. Given that this was years before the controversial academic study by Harvard’s Peter Tufano et al regarding Canada’s skyhigh MERs, Hamilton’s foreword was prophetic. At the end of it, he noted that while American investors can find no-load funds with MERs under 0.25%, Canadian investors could not [this was before ETFs became so prevalent.]

Finding how many years a third of your investment will be lost to fees

The Rule of 40 is a way mutual fund investors can estimate the number of years it takes for a Management Expense Ratio (MER) to consume a third of the initial investment. You divide the number 40 by your fund’s MER and that tells you how many years it will take for a third of the investment to be lost by fees. So for the 2.1% average of Canadian funds in 1998 (not much different today), divide 40 by 2.1 to get 19 years. A fund with a 3% MER would take just 13 years. The video describes the much longer time it would take for modern low-MER ETFs to lose a third.

In the foreword, Hamilton likened paying a 2% MER for 20 years to paying a 33% front-end load. It wouldn’t matter if investment managers could beat the markets by 2 or 3% a year but research shows most do not do that well. “They can’t beat the market because they are the market.”

This issue is especially important for retirement savings because contributions typically are invested for long time horizons like 20 or even 30 years. Hamilton noted that mutual funds are okay for newcomers and for filling in portfolio gaps in niches like small-caps or emerging markets and also make sense for the financially inept plagued by poor judgement. In that case, paying others to manage your money is a good idea regardless of cost: “You won’t do well but you wouldn’t have done well anyway.”

Vanguard Canada’s entry into ETFs a game-changer

The foreword’s conclusion is revealing, seen from the vantage point of 2012, when ETFs have made it far easier for Canadians to vote with their wallets for lower fees. As I note in the video, the entry of Vanguard Canada into the ETF space is a significant development in this ongoing saga.

Here’s an excerpt from near the end of Hamilton’s foreword:

… Canadians have only themselves to blame. We aren’t price sensitive. We either don’t know what we’re paying, or we don’t care. If the customer doesn’t care what the product costs, the producer has no reason to economize. High MERs mean better incomes for investment managers. They mean bigger profits for fund companies. They mean larger trailer fees for brokers. They mean fat advertising budgets. In the long run, everyone is happy — except the customer.

Until investors demand a better product by rewarding those who provide it and punishing those who don’t, Canadian mutual funds will have high MERs. And as long as MERs stay high, using mutual funds intelligently means using them less.

P.S. e-book on The Best of Jonathan Chevreau

Readers of the printed edition Tuesday Jan. 10th may have noticed an ad at the bottom of FP Investing for a new e-book edition of my recent columns (mostly from 2011). It’s structured in three parts: building wealth, wealth decumulation (drawing income) and financial literacy. As a bonus, I threw in the blog from 2010 on the Financial Literacy fable, which I link here because it relates directly to the Rule of 40 described above. You can download the new e-book here.